Why you Should Exit Debt Funds after Union Budget 2014-15?

IndianMoney.com Research Team | Monday, August 04,2014, 10:31 AM

What are debt funds?

A debt funds invests mainly in Government and corporate bonds, money market instruments such as commercial paper, certificates of deposits and even fixed deposits. If you invest in a debt fund the money you invest is safe and is returned to you after the maturity date with interest.

Popular debt funds

Fixed maturity plans

Gold funds

Debt mutual funds

Fund of funds.

Why were debt funds popular among tax savers?

You could invest in a debt fund particularly a debt mutual fund to save on your tax. If you stayed invested for over a year and made a profit this would be a long term capital gain and

Tax is charged at 10.3% on this gain without indexation.

Tax is charged at 20.6% on this gain with indexation.

If you invest INR 25000 in units of a debt fund in March 2011 and sold these units for INR 32000 in September 2012 you would get a profit of INR 7000.This profit is called a long term capital gain because you have held these funds for over a year.

Without indexation

With indexation

Indexation takes into account the effects of inflation on your investment. The capital gains are much larger owing to the effects of inflation not being considered when tax is calculated without indexation. This means you have to pay a higher tax on the capital gains. Indexation saves tax on capital gains by factoring change in the purchasing power of money due to inflation.

Cost of inflation index (CII) takes into effect inflation as shown in the table below

You have to pay a tax of INR 421 on your profits/gains of INR 7000. You could choose to avail indexation to save on your capital gains tax or opt for no indexation depending on the tax saving benefits.

What happens if you invest in a debt fund for under a year?

If you sell the debt mutual fund before a year the profits/gains you get are short term capital gains and these are taxed based on the income tax slab you fall under (marginal rate). If you fall in the highest tax bracket the tax rate is 30.9%.

Pre Union Budget 2014-15

Why do these changes affect you?

If you invest INR 25000 in units of a debt fund in March 2013 and sold these units for INR 32000 in June 2014 you would get a profit of INR 7000.Previously this was a long term capital gain.( long term capital gain >1 year). If you want to learn more about tax please read our tax planner ebook

Long term capital gains > 3 years and no longer > 1 year

If you sell the debt fund before 3 years the profits/gains you get are short term capital gains and these are taxed based on the income tax slab you fall under (marginal rate). If you fall in the highest tax bracket the tax rate is 30.9%. (You are taxed at the marginal rate of 30.9%).

This is unlike before when if you held a debt fund for over a year you got long term capital gain tax benefits.

Change in indexation laws on long term capital gains

You now have to hold debt funds for 3 years instead of a year to enjoy long term capital gain benefits.

With effect from April 1st 2014 long term capital gains are taxed at 20.6% with indexation.

Before the Union budget 2014-15 if you held debt funds for over a year and sold them at a profit you had long term capital gains which were taxed at 10.3% without indexation. You can no longer avail this benefit.

Effects

Death of debt funds and the fixed maturity plan?

Previously you could invest in an FMP (Fixed maturity Plan) and avail tax benefits on your long term capital gain after holding it for a year. An FMP gives returns higher than a fixed deposit but fund management fees eat up into its greater return and returns are similar to a fixed deposit.

FMP invest in Corporate/Company bonds which make them vulnerable to default risk.(You might lose the money you invest and also interest).Fixed deposits are safe and not subject to any risk. So why risk an FMP?

You would invest in an FMP because of its tax benefits as these being debt funds were taxed at 20.6% with indexation and 10.3% without indexation after holding them for a year. In a fixed deposit the interest you earn is added to your taxable salary and you are taxed as per the tax slab you fall under. If you fall in the highest tax bracket you are taxed at a marginal rate of 30.9%.As a result FMP was better than a fixed deposit because of tax benefits.

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IndianMoney.com Research Team

The research team at IndianMoney.com comprises of certified and experienced professionals who share the company's vision to make every Indian financially literate by equipping every Indian with right and unbiased advice. IndianMoney.com research team provides newsletters, articles, videos and FAQs on various financial products and concepts only to help you make wise financial decisions.